The Second Leg Down in Housing

July 2, 2010

In one of my previous editions of Headlines (Week of June 20, 2010), I summarized two articles which touched upon the state of our residential housing market.

In their State of the Nation’s Housing 2010, the Harvard University Joint Center for Housing Studies, pointed to a number of issues which will continue to affect the future of homeownership in this country for some time to come.

Among the issues in the report were persistently high unemployment, too many vacant housing units, the fact that people in their 20”s are wary of buying a house — even if they could afford to, the trend toward higher lending standards and the loss of the federal tax credit for home purchases

The only (and barely) good news in the report is that houses are more affordable than they’ve been in years. Nationwide, the median sales price dropped from 4.7 times the median household income in 2005 to 3.4 times in 2009. When combined with low interest rates, this puts mortgage payments on the median priced home closer to median gross rents than at any time since 1980.

This week I ran across an article written by Barry Ritholtz, CEO and Director for Equity Research at Fusion IQ. In it, Barry begins by providing a brief history of events following the 2000 Dot Com crash when Fed Chairman Alan Greenspan brought Fed Funds rates down to ultra-low levels and its net result –a credit bubble and a housing boom in which 10s of millions of Americans became, albeit temporarily, home owners.

In 1992, some 4 million homes per year were being purchased. A decade later, that number had risen 25% to 5 million. A mere 3 years later, annual sales were 7 million units — a 40% increase.

According to the National Association of Realtors, existing-home sales were at a seasonally adjusted annual rate of 5.66 million units in May. We are now back to levels achieved in the years 1997/1998.

He describes a situation in which buyers of limited financial means who en masse overpaid for their houses at ultra low rates created a recipe for disaster. As the Fed began its cyclical tightening, price appreciation slowed, then reversed. Sales plummeted, and prices fell. Five million of those buyers were foreclosed upon, with another 5 million likely to come.

Barry’s article agrees with the Harvard report but digresses on the main reason why the residential market will continue to be weak for many months to come.

He agrees that credit is now tight resulting in demand is far below what it was during the past decade. He agrees that unemployment is a critical factor holding back demand. He also agrees that inventory is extremely elevated and that a huge supply of shadow inventory is out there, including speculators, flippers and bank owned real estate (REOs) who overpaid but have held onto their properties to await modestly higher prices to sell.

He is also one that believes we are barely halfway through a decade long foreclosure surge.

In his analysis, price stands out as being the prime mover of the next leg down.

Home prices are still unwinding from artificially high levels, and remain over-priced. By using traditional metrics, such looking at US housing stock as a percentage of GDP or median income vs home prices or even ownership vs renting costs, Barry believes prices remain elevated.

From 1977 to 2010, the median U.S. home price was 4.1 times median household income. But as the charts indicate, home prices are still above that mean. Same with home prices relative to rentals, or housing value as percentage of GDP.

His bottom line is that prices must revert to a sustainable level … and we aren’t there yet.

Through a combination of mortgage modifications and buyers tax credits, the government has managed to temporarily create artificial demand and keep more supply off of the markets.

Government policies temporarily stopped prices from finding their natural levels. Now that the tax credit has ended, and most mortgage modifications are failing, the prior downtrend in price will now resume.

Without what he calls –the heavy hand of the government intervening, the residential real estate market is will soon experience what price discovery is all about.

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